Bad Magic and a Slow Moving Train Wreck

The stock market advance since the lows of Feb 11th seems like magic. The market had the worst start to a year ever and suddenly, in the absence of any ‘good’ news, the market turns up? Don’t be fooled, it is not magic, just financial engineering. Corporate stock buybacks are the illusion that cannot last forever at these levels. HSBC has done research that states corporate buybacks are over $2.1 Trillion Dollars since 2010. Where do you suppose that money came from? Here is an answer from Economy and Markets, a publication of Dent Research: “On a cumulative basis, individual investors and pension funds haven’t contributed one ounce to the markets rise over that time (since the meltdown and recently). Every bit of it has come from these stock buybacks. If you’ve also read that the Fed has been responsible for virtually all of the stock market’s moves since the financial crisis, it’s really the same point. Low interest rates made it cheap for companies to take on debt then buy back their stocks. It is one way companies can juice their earnings per share because it reduces the share count. It’s a low-quality source of earnings growth. It has nothing to do with demand for a company’s products or services. It comes at the expense of innovation and research and development….and this source of earnings growth may be coming to an end (buybacks). And because individual investors and pension funds have largely been absent in buying stocks over this period, there will be little to support the market prices. Why would individual investors and pension funds all of a sudden come to the rescue when they’ve been on the sidelines the last seven years? These are the same individual investors who have seen their wages decimated and expenses skyrocket, (like healthcare and education), and now, all of a sudden they are going to buy stocks hand over fist?”

As stock buybacks dwindle, what will happen? Well it is happening, markets have turned. Over the last year the U.S. stock market, defined by the S&P500, has been unable to make a new high and in fact hit a new low this year. This low was last seen two years ago, and goes back to 2014. Investors are caught in a slow moving train wreck- a slow moving downward trending market. To help describe what is happening, MCS is introducing a visual to help. We are equating the levels of the S&P500 to drawers in a bureau; the drawers labeled in approximate numeric ranges of support and resistance like this:

Drawer 1) Market range, 2150-2100: The top drawer is capped at 2150 for now. The last time the market was in this drawer was last year, topping in May of 2015, at 2134 at the close, (intraday it was higher). When markets tried to recapture the 2134 number, they couldn’t, and instead made a lower high at 2120 in Nov of 2015. This drawer is closed to investors at this point and will most likely not reopen any time soon.

Drawer 2) Market range, 2100-2055: The market will most likely not see this drawer this year again either; it has just not been able to break into this range. This may seem subtle but is not, this the major confirmation of a trend reversal.

Drawer 3) Market range: 2055-1975: The market began the year in this drawer. On Dec 31st 2015 at 11:59 pm the S&P500 closed the year at 2043, and opened on the first trading day of the year, Jan. 4th 9:30 am at 2038. The S&P 500 closed on January 4th, the first trading day of the year, at 2012- over a 1% drop. Recently, the market has been experiencing a short term, short covering incident which has pushed the market into the upper limits of this drawer. The market will move down from this drawer very soon, but has spent about a third of the year in this range.

Drawer 4) Market range: 1975-1900- The market has also spent about a third of the year in this drawer and will return back to this drawer numerous times as the year progresses. MCS expects multiple moves between Drawers 3-6 due to the volatility in the market, which will allow other entry points into markets this year.

Drawer 5) Market range: 1900-1800- The market has also spent about a third of the time in this drawer this year too; and will renter this drawer again this year. At that time, should the markets break lower they will be in even more serious trouble. This event would trigger the next lower low. Every new low, and every new lower high (from the previous high) is an extremely negative factor for markets. These events reset trading algorithms and rebalancing for portfolios, and also affect other actions in the market that could exacerbate a strong decline.

The line in the sand happens when the drawer above is broken with a new low. We will update the lower drawer ranges when this occurs.

As the next earnings season begins, we must keep in mind the following: 2nd Q 2015 earnings per share showed 0% growth even with massive stock buybacks. Q3 2015 was negative, Q4 2015 was negative, and Q1 2016 is estimated to be negative as well. Three quarters of negative share growth is a serious problem, especially when there is no indication of improvement in the fundamentals of most U.S. Corporations. There is every indication that buyback programs will decrease and that earnings will continue in a negative trend for most U.S. companies. Companies are being forced to reduce their buyback programs as the rating agencies lower their debt ratings, reducing borrowing capacity. Companies that are increasing their debt to buy back shares will eventually have to discontinue this practice known as financial engineering. This will also lead many companies to reduce their dividend payments; (some companies to cancel the dividend altogether) to maintain their balance sheets and in dire cases the viability of the company. Without these buyback programs, there are few buyers left supporting the markets. It is very possible to enter lower drawers this year if the fundamentals continue to deteriorate. To many investors, this appears to be happening in slow motion. It may be easy to miss the nuance; but markets don’t usually turn on a dime. Markets go down in steps, slowly at first, then quickly at the end. Keep these lower levels, (or drawers), in mind for later this year and into next year.

6th : 1800-1725
7th: 1725-1650
8th: 1565-1650
9th: 1565-1400

In closing, we have already been in the 5th drawer this year and spent a good deal of time in the 4th drawer this year. We not only expect to retest drawer five, but there is a very high likelihood drawer eight or nine could be reached sometime before the end of the year. Should that happen- market gains going back to 2000 will have been eliminated from most portfolios- but not from MCS portfolios. Further gains for global equities are likely to be limited by a poor profit outlook. Corporate productivity continues to deterorate, combined with declining profit margins during a time of lackluster demand- all a very dangerous mix. Kindly keep in mind that a topping process for the U.S. markets may seem slow moving. In the end it is still a train wreck, leaving behind decimated portfolios. The good news is that markets are reacting to data in a normal fashion which will continue to allow entries for MCS in low risk investments.

Our thoughts and prayers go out to those victims of the terror attack in Belguim. These incidents are becoming all too frequent. Any reference to trains in this blog is a coincidence since the blog was mostly completed prior to this event.

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